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Editor’s Note: On Friday, we shared a crypto update from TradeSmith’s Chief Research Officer, Justice Clark Litle. Today, he’s back with his insights (shared last week exclusively with his Decoder subscribers) on the impact of El Salvador’s Bitcoin move on the broad crypto space. What is happening in the crypto space is unprecedented, so we are sharing his perspective, once again, with our TradeSmith Daily readers. Keith will be back tomorrow with a deep dive on short squeezes.
We couldn’t help but laugh at this Sept. 10 Wall Street Journal story:
CRYPTO FANS BORROW TO BUY HOMES, CARS — AND MORE CRYPTO
Upstart lenders make it easy to take out loans backed by cryptocurrency holdings. Regulators are watching.
Michael Anderson mined bitcoin in his dorm room and left a corporate job to invest in cryptocurrency projects. When he bought his first home in San Francisco this year, he didn’t turn to a bank. Instead, he borrowed against his cryptocurrency.
Crypto enthusiasts such as Mr. Anderson are tapping their holdings to buy homes, cars and, often, more crypto. They are getting these loans from upstart nonbank lenders and automated, blockchain-based platforms…
Multiple factors contributed to the 2008 global financial crisis. But one of the biggest factors was the implied belief — on the part of investment banks and U.S. homeowners alike — that home prices could never go down.
It was the assumption that home prices could not fall, coupled with extraordinary access to leverage, that allowed banks to carry real estate and mortgage portfolios leveraged as high as 30-to-1, while allowing average Americans to borrow against multiple homes on a $50,000 income.
The U.S. housing market is in significantly better shape in 2021, even though prices are high, because lending standards have tightened up dramatically. There is a legitimate housing shortage in the United States today, in part because builders are more conservative and banks will no longer hand out mortgages to anyone who can fog a mirror.
And yet, when it comes to finance, the lessons never actually get learned. The party just moves elsewhere.
So it is with crypto today. In the pre-2008 housing bubble, a term thrown about by real estate brokers was NINJA loans, where NINJA stands for “no income, no job or assets.”
NINJA loans are no longer a thing in U.S. real estate, but their mutant counterparts are alive and well in crypto, powered by a deeply held belief that “crypto prices can’t go down,” just as home prices once could never go down.
It isn’t the fervent belief that causes the problem. It’s the leverage on top of leverage enabled by the fervent belief that creates unsustainable price increases followed by inevitable severe price declines.
And in crypto’s case, the leverage is unconstrained by any type of regulation whatsoever, which creates a triple-shot nitroglycerine cocktail: massive leverage on the part of all-in crypto enthusiasts; massive leverage built into the business models and capital exposure levels of the exchange operators and promoters; and last but not least, something even worse than leverage on the part of the dollar-backed stablecoin operators, the biggest of whom are likely exposed to imploding Chinese real estate developers.
When a crypto enthusiast leverages their crypto portfolio to buy even more crypto, and the same thing is happening all across the space, and the crypto space itself is filled with pump-and-dump business models running at full tilt, you don’t need a horde of bears stomping in to ruin the party. All you need is a modest correction — the sort that any healthy market should be able to deal with — that becomes big enough to trigger an inevitable leverage unwind as “HODLers” become forced sellers at the worst possible time.
Put it all together, and it is more or less one of the most predictably bad situations we’ve ever seen.
But hey, we didn’t even intend to talk about that today — the Wall Street Journal headline just brought about those spontaneous insights.
The planned topic at hand was El Salvador’s Bitcoin experiment, and why it is bad.
El Salvador — or rather the El Salvadoran government — is doing Bitcoin completely wrong. This will almost certainly be bad for the country, Bitcoin, and the crypto space on the whole.
They Should Have Just Mined It
Bitcoin offers real opportunity to developing-world countries. But the opportunity comes in the form of adding value to the economy through a stable business model. The way to go here is sustainable mining operations.
A country like El Salvador could encourage Bitcoin mining through the use of renewable energy sources. The government could then provide funding and support for such mining operations in exchange for a share of profits, or it could own the Bitcoin mining operations outright.
A government like El Salvador’s could also do joint ventures with professional Bitcoin mining operations, in the long-standing manner that countries lacking oil and gas expertise have partnered with energy companies to develop local energy resources.
If a country approaches Bitcoin through sustainable mining, it reaps multiple benefits.
First, it creates new jobs and cultivates a new industry.
This can be a significant win for the local economy, especially if the power sources are renewable — thus also seeding the potential expansion of renewable energy, a surplus of which could be sold to other countries.
Second, the country now has an organic source of Bitcoin flowing into its reserve accounts.
If you mine the Bitcoin locally, you don’t have to buy it on the open market, and the mined Bitcoins can be held for price appreciation as a form of foreign exchange reserves.
Third, the Bitcoin accumulated as reserves can be used as a volatility buffer. This is the main point of accumulating foreign exchange reserves in the first place.
The greater the quantity of foreign exchange reserves (including gold) a government has, the more ability that government has to keep its local currency stable. This can be a real advantage for the local economy.
The smaller a country’s economy, the greater the exposure that country has to volatility in the global economy. Think of boats bobbing up and down on ocean waves. A small, developing-world country is like a little boat.
This is why an accumulation of foreign exchange reserves is a good idea for small countries. If the local economy and currency is tossed around by global volatility, government leaders can use some of their reserves to balance things out.
Which brings us back to Bitcoin mining: If a country like El Salvador were to accumulate Bitcoin in its reserves over time, the government would gradually increase its ability to stabilize and invest in the economy to promote new growth industries.
But the above is not what El Salvador’s president, Nayib Bukele, chose to do.
What he chose to do instead is flat-out dumb.
Understanding the Function of a Reserve Asset
The best way to think about Bitcoin is to see it as a form of digital gold, or dematerialized gold. There is a case that Bitcoin can do the same job as gold but even more efficiently.
And what does gold do best? It functions as a reserve asset, on scales both large and small. That means gold is like a form of insurance.
- Gold is held by hundreds of countries, and accounted for as part of their foreign exchange reserves, as insurance against a rainy day. If things get bad, the gold will be there as something that will hold value, or may have even skyrocketed in value.
- Individuals and businesses hold gold for much the same reason. Palantir Technologies recently announced it is buying gold bars as a hedge against a “black swan event.” It is the same idea for people and businesses as for countries: Gold is an asset that will be there in a time of crisis.
And yet, owning gold as insurance and owning gold as a speculation are two very different things.
If the price of a reserve asset moves around a lot, it doesn’t matter much. Why? Because you are holding it as a reserve asset. By definition, that means holding it in amounts appropriate for a form of insurance.
Even for countries that heavily weight their foreign exchange reserves toward gold, the total amount of the reserve pile is small relative to the size of the overall economy.
This is akin to, say, an investor putting 5% to 10% of their portfolio into gold and Bitcoin as a form of insurance. If you see volatility in a modest percentage of your portfolio, that is fine. You can handle that and deal with the volatility in advance.
But putting 100% of one’s portfolio in gold — or even cash savings — would be a terrible idea.
Imagine if someone told you that, as of next month, you had to put 100% of your savings into gold. All of it, including all the money you used to pay your mortgage, electricity bill, everything.
Would you be comfortable with that? Probably not, because now you are exposed to gold’s volatility in a way that could hurt you. What if the price of gold falls 20% from here, even as your monthly costs stay denominated in dollars or something else? That would be really painful. It might even reduce your ability to pay bills.
You Don’t Force Volatility on People With No Savings
Everything we described above regarding gold applies to Bitcoin even more so, because the Bitcoin price is far more volatile than the gold price.
This is why forcing people — especially poor people without significant savings — to do business in Bitcoin is a shockingly bad idea.
For an individual person to use Bitcoin as a reserve asset, they need an amount of savings they can set aside. They need some amount of funds — even if just a small amount — for which they can say “I will invest this amount and not worry about the volatility.”
Impoverished people obviously do not have this spare amount. All of their available funds are designated for buying food, buying electricity, or otherwise keeping their home or small business up and running.
These people have no stomach for excess volatility because they literally have no savings to speak of. To force them to accept volatility — by forcing them to take on Bitcoin exposure with effectively 100% of their assets — is madness.
It has been said that Bitcoin can be a godsend for individuals in countries with unstable currency regimes. And in a certain light, this is true.
But the key idea here is that Bitcoin ownership has to be voluntary to be a benefit. That means the individual decides how much of their portfolio to allocate to Bitcoin.
If, instead, the government forces Bitcoin adoption on people as El Salvador is doing now, the whole “voluntary” part gets trashed.
That means millions of individuals with insufficient savings are suddenly exposed to volatility they did not want or ask for, by government decree.
Meanwhile, the El Salvadoran government itself is taking a huge gamble on Bitcoin volatility.
President Bukele is essentially making the same bet that Michael Saylor, CEO of MicroStrategy, is making. Both are betting everything on the assumption that Bitcoin will not see enough of a price decline to blow them up.
In the case of MicroStrategy, it is literal financial leverage (putting borrowed money into Bitcoin purchases). With regard to Bukele, it is political leverage and the risk of mass uprisings.
If you force a nation of people to transact in a cryptocurrency they are unfamiliar with, and then the value of that cryptocurrency declines sharply at a time when confusion and frustration is already at a fever pitch, you are going to get mass civil unrest.
Unfortunately for the El Salvadoran people, Bukele was already showing authoritarian tendencies, which means that mass civil unrest relating to Bitcoin volatility might result in brutal crackdowns and Bukele cementing his power in the style of Hugo Chavez or Fidel Castro.
How would such a human tragedy, with Bitcoin at its center, look for Bitcoin?
You Don’t Get Autonomy By Ceding Control
With regard to El Salvador force-adopting Bitcoin as legal tender, we are only scratching the surface of the problems and risks involved.
Another serious concern is that, if the Bitcoin price sees a significant decline, Bitcoin whales (the small percentage of individuals who own massive amounts of BTC) could use El Salvador as a forced exit. Meaning, because the El Salvadoran economy uses the U.S. dollar as legal tender — and now requires the acceptance of Bitcoin alongside — those wishing to exit their Bitcoin holdings could suck all the dollars out of the El Salvadoran economy.
Then, too, a supposed rationale for adopting Bitcoin as legal tender was to help give El Salvador more control over its destiny and future.
But you don’t gain control by forcing exchange-rate volatility onto millions of citizens. And if the source of that volatility is out of your hands, you wind up ceding control to other forces.
This also goes back to the purpose of foreign exchange reserves. A country acquires reserve assets for the same reason a person does: to provide a buffer against unwanted volatility.
As such, a functional government will actually reduce the amount of volatility experienced by the local economy, and its citizens, by using reserve assets as a buffer in a time of crisis.
What El Salvador is doing, in forcing Bitcoin on its citizens as legal tender, is increasing, rather than decreasing, the amount of volatility experienced by the El Salvadoran economy.
But what if Bitcoin just goes up a lot from here? Won’t that be great for El Salvadorans?
Not necessarily. The El Salvadoran economy relies heavily on remittances from family members overseas, which means a large inflow of foreign currency every month.
That means the El Salvadoran recipients of those remittances will have to become active foreign exchange managers as their inflows and their costs start jumping back and forth between U.S. dollars and Bitcoin.
Then, too, prices, and possibly wages, will have to start moving around, whether or not Bitcoin goes up or down. And if Bitcoin has a gigantic spike in either direction, for reasons wholly out of El Salvador’s control, it will wreak havoc.
Bukele Wanted a Magic Bullet
We are still hardly scratching the surface of all the reasons why El Salvador’s move was bad.
Another issue is that Bitcoin, while perfectly suited to function as a reserve asset, is nowhere near suited to functioning as a day-to-day transaction mechanism.
Bitcoin, like gold, is not really designed to move around a lot. Bitcoin and gold both function well as reserve assets that mainly change hands for investment purposes, rather than, say, hundreds of times a day for small purchases.
It is entirely possible to build a payments layer on top of Bitcoin, so that the Bitcoin itself does not have to move hundreds or thousands of times because the lighter-weight payments layer is doing that.
But that aspect of development is still underway — and it isn’t ready for prime-time rollout yet, let alone a rollout in which millions of people are forced to accept beta- or even pre-beta-level solutions as a disruption to their daily commerce.
Not to mention that Bitcoin’s implied desirability as a deflationary asset is in direct conflict with the notion of transacting with it daily in the first place.
Bitcoin as a reserve asset — doing the same job as gold — makes perfect sense. As a reserve asset, the volatility doesn’t have to matter, and the upside volatility is a feature rather than a bug. At the same time, holding Bitcoin with a combination investment and insurance mentality is a great fit.
Then, too, Bitcoin as an asset that sits on government balance sheets — to help balance out volatility in times of crisis — makes perfect sense, as does an embrace of sustainable-energy Bitcoin mining to grow a new local industry.
And yet, what El Salvador is doing just skips past all that, in a manner that is remarkably foolish, to force legal tender adoption on millions of angry and wary citizens in a manner that is likely to create disaster.
And as to the problem of excessive fees on overseas remittances, why didn’t they just embrace the Stellar network, or some other solution for reducing transfer fees without forcing the legal tender option?
Our hunch is that President Bukele wanted some kind of magic bullet. He wanted a fix for El Salvador’s broken economy that would transform the country’s outlook overnight — on the surface anyway — and garner a lot of press for being a flashy and cool solution. (The mandated El Salvadoran Bitcoin wallet is even called Chivo, which is slang for “cool” or “awesome.”)
Wild enthusiasm from the crypto community for the public relations aspect of Bitcoin becoming legal tender surely also appealed to Bukele, who is very much a hip, cool, and social-media-savvy millennial.
The future is best constructed by heeding the lessons of history — not by forgetting or ignoring all that was learned, pumping the nitro boosters with myopic greed, and rushing headlong into a wall.